Financial Market Panic: Losing Our Marbles

Steve Waldman explains how the house of cards can collapse:

Credit Crisis for Kindergarteners, by Steve Waldman: David Leonhardt notes that it's pretty hard to explain what's going on in the financial world these days... Here's how I'd tell the tale to a child:

Alice, Bob, and Sue have ten marbles between them. Whenever one kid wants another kid to take over a chore, she promises a marble in exchange. Alice doesn't like setting the table, so she promises Bob a marble if he will do it for her. Bob hates mowing the lawn, but Sue will do it for a marble. Sue doesn't like broccoli, but if she ... promises a marble...

One day, the kids get together to brag about all the marbles they soon will have. It turns out that, between them, they are promised 40 marbles! Now that is pretty exciting. They've each promised to give away some marbles too, but they don't think about that, they can keep their promises later, after they've had time to play with what's coming. For now, each is eager to hold all the marbles they've been promised in their own hands, and to show off their collections to friends.

But then Alice, who is smart and foolish all at the same time, points out a curious fact. There are only 10 marbles! Sue says, "That cannot be. I have earned 20 marbles, and I have only promised to give away three! There must be 17 just for me."

But there are still only 10 marbles.

Suddenly, when Bob doesn't want to mow the lawn, no one will do it for him, even if he promises two marbles for the job. No one will eat Sue's broccoli for her, even though everyone knows she is promised the most marbles of anyone, because no one believes she will ever see those 17 marbles she is always going on about. In fact, dinnertime is mayhem... Mom is cross. Dad is cross. Everyone is cross. "But you promised," is heard over and over among the children, amidst lots of stomping and fighting. Until recently, theirs was such a happy home, but now ... no one trusts anyone at all. It's all a bit mysterious to Dad, who points out that nothing has changed, really, so why on Earth is everything falling apart?

Perhaps Mom and Dad will decide that the best thing to do is just buy some more marbles, so that all the children can make good on their promises. But that would mean giving Alice 19 marbles, because she was laziest and made the most promises she couldn't keep, and that hardly seems like a good lesson. Plus, marbles are expensive, and everyone in the family would have to skip lunch for a week to settle Alice's debt. Perhaps the children could get together and decide that an unmet promise should be worth only a quarter of a marble, so that everyone is able to keep their promises after all. But then Sue, the hardest working, would feel really ripped off, as she ends up with a much more modest collection of marbles than she had expected. Perhaps Bob, the strongest, will simply take all the marbles from Alice and Sue, and make it clear than none will be given in return, and that will be that. Or, perhaps Alice and Bob could do Sue's chores for a while in addition to their own, extinguishing one promise per chore. But that's an awful lot of work, what if they just don't want to, who's gonna force them? What if they'd have to be in servitude to Sue for years?

Almost whatever happens, the trading of chores, so crucial to the family's tidy lawns and pleasant dinners, will be curtailed for some time. Perhaps some trading will occur via exchange of actual marbles, but this will not be common, as even kids see the folly of giving rare glass to people known to welch on their promises. It makes more sense to horde.

A credit crisis arises when many more promises are made than can possibly be kept, and disputes emerge about how and to whom promises will be broken. It's less a matter of SIVs than ABCs.

Couldn't the parents force the kids to keep their promises (under threat of a large penalty for default)? Either do what you promised, or incur some punishment that makes doing the chores the only reasonable choice? That seems a lot like the way a court would enforce contracts, so we need one of the kids to declare bankruptcy (or simply refuse to work and accept the punishment of having assets stripped, getting sent to their room, grounded, etc.) to get this going.

Perhaps another way to make this work is to have one of the kids lose their marbles (literally, as in a bad investment) so that some debts cannot be repaid. This would break the chain, create worry and panic, and potentially generate a breakdown in the system. But in this case the role of the government (parents) is easier - if it acts fast enough it could replace the lost marbles using its magical marble making machine (print money), three or four perhaps, to make a loan backed by collateral to keep the system of credits and payments flowing.

As for the child who lost the marbles, the parents could teach him or her a lesson about being responsible by refusing to come to the child's aid, but that just wrecks the entire household - the other kids didn't do anything wrong. Better to loan the child the marbles to keep things flowing, enforce existing contracts, then once the crisis is past, determine how and why the marbles were lost. At that point, if there is reason for the child to bear the consequences of bad choices, then the consequences can be confined to the child rather than spread throughout the household. In addition, the parents could also consider instituting new rules (a regulatory response to the crisis), e.g. automatic penalties for non-performance of a contract (e.g. capital requirements, forfeiting a bike or some other toy to the other party, etc.) so that once a deal is agreed upon, the kids are less likely to renege, rules about how marbles can be stored so they aren't lost accidentally, and so on.

Comments

[Marbles]

"...marbles are expensive, and everyone in the family would have to skip lunch for a week...magical marble making machine..."

There is no free lunch. The marble making machine is not magical. To give more marbles to borrowers, you must take some away from someone else.

You can create an infinite number of Federal Reserve Notes, but this does not actually increase the supply of scarce consumer goods. If you give more consumer goods to borrowers via money creation, you can only do so by taking consumer goods away from someone else. A story that does not tell who you are taking consumer goods away from, and the consequent effect on their behavior, is incomplete.

[swells]

Marbles, I think you missed a point. One that is actually quite pertinent to a lot of the discussion that goes on here. Yes, consumer goods are "scarce" in the manner you discuss but the pool of those same consumer goods are not static over time. There is a phenomena called growth. I think it is clear, for instance, that there is a bigger pool of consumer goods now than existed in say, 1950. It is possible to take the course of minting some new marbles now and, by cutting back consumption in the future, make the whole thing work. Cutting back in the future, coupled with growth, will at some point bring the relative value of a marble back to parity with the value of a marble pre minting some new ones to get us out of a current crisis.

However, unless the cutting back in the future happens, that won't be the case. So, yes, we can mint some new marbles now to tide us over a rough patch but we really shouldn't do that without being aware that the cutting back in the future will exact a price at the time the cutting back happens.

Unless growth is at such a high rate that even taking into account the cutting back in the future we (or our descendents) will be relatively better off than we are now we should be extremely cautious about minting new marbles.

The only way it makes sense is if NOT minting new marbles will wreck things so badly that we and our descendents will be worse off than we are at present. This may be one of those times. But, I'm pretty sure we have been minting new marbles like crazy in circustances where it WASN'T one of those times for quite a while now.

[Organic George]

Marbles ......................?

We are talking about a regulated financial system where companies are not supposed to make obligations that they cannot keep.

Here's a better parable. Man robs Peter, Mary and Sam of their marbles. Man is disgorged of his ill gotten gains and is sent to a 15 year time out.

Why can't you just come out and say that Wall St was involved in illegal fraudulent transactions?

Accepting this fact is the first step in your recovery from fantasy land

[IdahoSpud]

Mom and Dad should reach into the bag of marbles that they have saved since 1913. Then they should loan the bulk of the marbles to the kids (for an unknown length of time), and hope that:
a) the children continue to do their chores, and
b) stop promising more marbles than they actually possess

[Alex Tolley]

How exactly did the marbles become 40 after the netting of promises? This isn't a very convincing model for the mortgage mess.

[bullbust]

Socializing losses, brought to you by your glorious Fed.

http://www.nakedcapitalism.com/2008/03/primary-dealers-get-flattering-marks-on.html

A professional investor alerted me to a not-widely-noted element of the Fed's new discount window clone for primary dealers, the so-called Primary Dealers' Credit Facility (I am going to lose track of the acronyms given the speed with which the Fed is coming up with new ways to socialize losses).

What collateral is eligible for pledging?

Eligible collateral will include all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Open Market Trading Desk, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available.

How will collateral be valued?

The collateral will be valued by the clearing banks based on a range of pricing services.

That sounds objective and innocuous, right? Guess again. As the investor commented:

Note also that the Fed’s accepting the clearing banks’ valuations on the assets that the brokers present as collateral. That is so very understanding of them. Given that the clearing banks hold similar assets themselves, they are probably grading on a curve here, so as not to mark down their own assets simultaneously, I’m guessing. We’ll give the best student here an A—make that a triple A!—and hey, look, we’re all triple A on this bus. Yikes.

[William Smith]

Prof Thoma,
The disadvantage from the "wait, investigate and determine the proper punishment" is that certain major players will have exercised a $100 million golden paracheute and retired to the Bahamas and the political will to act will have dissapated. This is a situation where the iron is hot, so to speak, and even if it could hurt the rest of the country (of which I have my doubts), must be properly used now, not later.

[Alex Tolley]

Shouldn't the parents have explained to the kids up front about the rules of promising and paying marbles BEFORE they started to play? Aren't the parents partly responsible for the mess created. Perhaps the parents need to go have their evening out privileges revoked?

[esb]

I know these brats well.

These particular little brats actually made fifty-three trillion promises.

The brats simply cannot be trusted.

The brats need an entirely new system.

With these brats simple punishment is not going to be enough.

These brats need to be policed,

highly policed.

Even that might not be enough,

not with these brats.

[Poor kids]

Hold on, in reality, these kids only have 10 marbles showing, but they have millions of marbles they recieved in bonuses in the past 10 years. Why is it they can only use the 10. Maybe their parents should tell them to go get the marbles from the past bonuses and pay up.

says...

there are many reasons the extended allegory
is today
as dead as the mid-eval catholic church

somethings are even more tedious then algebra

but mark as much as the fabric bores me
i commend your pains taking
reweave

[paine]

is it really true
you can't punish people productively ???

that is unless you make their punishment
be more work

most economic punishment
job loss company bankruptcy
reduces the right now aggregate work put

and from a design of the whole persepective
we need to max the long run social work put right???

given the wild ride we call
progress thru corporate capitalism
with all its spells of idled real capacity
at what point
do we say
enough of this alibi for episodic slackery
forget the clever counter
to the venerable old adage
"a minute idle is a minute lost
to the great satan"
is it actually true
in a systemically unconstrained setting
that
"we lose long run work put
by following to closely this
homely heuristic
about full playgrounds
and empty job sites

[donna]

My kids believe there's a magic cupboard and refrigerator that get miraculously restocked too.

But then I didn't let them run Bear Sterns, either.

[skate]

If you look close, you'll find that "consumer goods" were taken away, in order for the economy to work.
The goods were taken from the truck drivers (80s/90s)in order to keep down the COST to everyone else.

Take a Close look again, you will see that the turn rate of Long Haul Drivers is WELL over 100%.

skate

[ken melvin]

The house of cards is the more apt analogy. Any ideas of propping up same are daft. There was nothing behind the screen at Bear Stearns. How many other Bear Stearns? And, there is nothing behind this whole 'service'/'financial' economy.

[paine]

skate

great point brother

[paine]

"The house of cards is the more apt analogy. Any ideas of propping up same are daft. There was nothing behind the screen at Bear Stearns. How many other Bear Stearns? And, there is nothing behind this whole 'service'/'financial' economy"
i agree

the approach is wrong ended

gotta get the base fixed
by uncle buying up
all the original mortgages
any one wants to sell
at face value
will cost zillions but
money costs uncle nothing

inflation

hey the green toes were fearing inflation
from 1930 till 1940
meanwhile we ideled one third of a nation
on and off for ten years

the tumble down won't end till we do

[esb]

ken melvin:

Wrong.

There was something behind this financial economy.

The office, the desk, the phone, the con man, the sucker and

a wildly, insanely accomodative central bank.

And here we go again.

Whee.

(Barney Frank's lamentations have been that there was no place for him in all of this.)

There is Barney, they're working on that right now.

[Spectator]

The marbles analogy is pretty good, and Marbles in the first post exposed the fallacy in Mark Thoma's and most economists thinking. There is no magical machine to print money - it comes at a cost to society.

The next commenter said growth/progress would take care of the printing. Yes, but what you don't see is the lower costs we would have experienced without the printing. Either way it's stealing from the public. This common sense fact goes counter to the dubious economic models drilled into many economists heads.

[James]

Maybe the Fed can open the discount window to hedge funds and large traders.

[sewells]

Spectator, I did say growth/prgress COULD take care of it but only by cutting back later. That cutting back would take the form of lower prices we don't experience. I think it's actually a bit worse than stealing from the public. If it were just stealing from the public then it would be stealing from those irresponsible enough to let themsleves be stolen from that way. Mostly what concerns me is that we're stealing from people who haven't even been born yet.

[Spectator]

sewells, sorry I did not do justice to your comment. Was trying to make a point. Fully agree with you that it's worse than stealing from the public.

Money is the basis of our society. I think we underestimate the damage to the fabric of society, and other destructive effects of monetary distortions. Keynes is central to many of the dubious economic models. But he had a wonderful turn of phrase, and did capture the dangers of printing money in this quote.

"There is no subtler, surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose."

[IdahoSpud]

The problem with this analogy is that these aren't innocent children, they are sophisticated and (probably) amoral financiers with a great deal of political power.

The Fed has, by anonymously lending huge amounts of money, temporarily allowed these financiers a thin veneer of financial solvency. At this point the financial system looks suspiciously like a Potemkin Village.

The fact that many of these players are still paying dividends and executive bonuses, while in deep financial trouble, speaks for itself.

[James]

What do YOU Think Mom and Dad Should Do about the Children?

http://jessescrossroadscafe.blogspot.com/2008/03/credit-crisis-for-kindergartners-with.html

[Barry]

Mark: "Better to loan the child the marbles to keep things flowing, enforce existing contracts, then once the crisis is past, determine how and why the marbles were lost. At that point, if there is reason for the child to bear the consequences of bad choices, then the consequences can be confined to the child rather than spread throughout the household. In addition, the parents could also consider instituting new rules (a regulatory response to the crisis), e.g. automatic penalties for non-performance of a contract (e.g. capital requirements, forfeiting a bike or some other toy to the other party, etc.) so that once a deal is agreed upon, the kids are less likely to renege, rules about how marbles can be stored so they aren't lost accidentally, and so on."

Mark, for ~30 years now the regulatory systems have been dismantled, even as various crises have come and gone. Unless something radially changes, I expect the near future to resemble the near past.

[sewells]

Spectator, would it make sense to mint new marbles if the newly minted marbles were productively invested; i.e., were put toward productivity gains that, by virtue of compounding, could actually pay back their own cost and more? I think it could. Something like this is almost certainly what is at work when a farmer borrows money to open new fields up to cultivation, etc.

I think that is the kind of fig-leaf that gets hidden behind when selling the concept of risky derivatives and the like. I'm on shaky ground here as my economics education is not up to snuff but is there any aspect of the kind of financial speculation we are talking about that falls into this category? It seems to me that when the risky schemes are getting hyped and sold that they are clothed in a growth rhetoric but are not actually productivity increasing endeavors for the most part.

[Barry]

Alex Tolley says...
"Shouldn't the parents have explained to the kids up front about the rules of promising and paying marbles BEFORE they started to play? Aren't the parents partly responsible for the mess created. Perhaps the parents need to go have their evening out privileges revoked?"

You're doubleplusungood here, Alex - this is SocCom Regulation! Restraining the optimization of the free market, tying the Invisible Hand!

[paine]

okay i give in

these kids we're really talkin about

are from the village of the damned

btw
what in hell is barry burbling

[TigerPaw]

It should also be noted that the children screamed and demanded that Mom & Dad leave the room while they were playing; insisting that they were mature enough to play responsibly and threatened to hold their breath if Mom & Dad wouldn't leave the room.

So Mom & Dad did leave the children alone to play. The level of maturity of the children is of course obvious after the fact (if not before). The strange part though is that Mom & Dad still have this weird idea that maybe it might still be OK to leave the children alone to play unsupervised.

Must be an overly permissive 1960s Mom & Dad.

[paine]

"Maybe the Fed can open the discount window to hedge funds and large traders"

james
i knew you were a wall street spec tart
but ... spreadin for hedge funds ....

[paine]

spectator

that's catnip quoting mr K

[paine]

case of
"never worry i see with my hands "
said by a blind man as he staggers down the hall

"There is no magical machine to print money - it comes at a cost to society"

could anything
contained in just two phrases and 15 words
be much more dangerously primitive and wrong headed

[paine]

"Why can't you just come out and say that Wall St was involved in illegal fraudulent transactions?

Accepting this fact is the first step in your recovery from fantasy land"

precisely
orgeous george
precisely

[ST]

I don't think this is such a hard problem: Alice is bankrupt (she made promises she couldn't keep). Sue is upset, because Alice is bankrupt -- but she should have known better than to accept IOUs from someone like Alice.

Neither Bob nor Sue is likely to accept Alice's promises anymore -- so Alice gets punished, because she has to do all of her own chores. There's no reason Bob and Sue can't keep trading, except that Sue who should be rich is out of marbles (she paid up, but never received what was owed her).

What the parents need to do is keep Sue in the game, by giving her a loan of marbles but at the same time requiring that she pay them back. Since Sue is in fact the most productive member of the bunch this actually should not be very difficult. Thus Sue never goes bankrupt, even though she had bad judgment in lending to Alice, and we keep the most productive member of the economy trading.

The tricky part here is to make sure that you only give loans to Sue, who will pay them back, and not to Alice, who will not pay them back.

A proposed solution to the credit default swap problem along these lines is here.

[Steve Waldman]

Alex,

A credit crisis is a phenomena of unconsolidated balance sheets.

The numbers presented in the tale can be made to work just fine. For the truly obsessive, I've added sample balance sheets to the original post. (Note that the post indicates that each child expects to enjoy her assets on demand, but settle her liabilities at a later date. That's realistic too -- it's why the "money supply" that we perceive and use is much larger than the monetary base. People who borrow from banks against collateral perceive that they have money. They don't net their own balance sheet.)

[James Killus]

A few days ago, on the von Mises Instititute comment thread, I noted something similar to the marbles analogy and everyone misunderstood it. I later posted a follow-up, but that's now the end of the thread, so what the hell, I'm going to repost it:

I'm sorry that I was out for a day, as everyone seems to have misunderstood what meant when I said:

All pension schemes transfer goods and services from one generation to another.

People seem to believe that money is a good or a service. It is neither. It is the promise of purchase of a future good or service. Likewise, "investments" are also promises of value transfers in the future.

No pension scheme socks away food, clothing, housing, medical care (as if that were possible) to give to pensioners later in life. All pension schemes depend upon future claims to those things, transfers between generations, just as a bond is a promise to transfer money later, and money is a promise to transfer goods and services later.

People tend to be so hypnotized by the propertarian, monetarian world-view that they forget just how contingent all these things are--until some crisis comes along and reminds them that promises are still just promises, laws can and are changed, and "every man for himself" works exactly as long as that man is the meanest son of a bitch in the valley, and as soon as he falters, his bones are striped and left for the vultures.

What is true for pension schemes is true for money and financial instruments generally. The ongoing error for many is the confusion between the financial economy (the network of promises) and the real economy (the production and exchange of goods and services). Try meditating on that "The Map is not the Territory" thing. Also, there is an old vaudeville joke, once seen on the Dick Van Dyke Show to the same effect as the marble thing.

[paine]

marble ous steve
by implication
condemns the free and private enterpise system

"A credit crisis is a phenomena of unconsolidated balance sheets. "

jan tinbergen i think called this secondary uncertainty
ie
not part of ..."that's life bub"
but part of
the carry cost of running
an opaque by design enterpise system

to wax karlian

the credit system is a partial sublation of capitalism

as with any partial solution
trouble abounds at the contradiction points

seems every time
the bridge building crew
are just about
to reach the far side of the river ...

recall
penelope's loom and the suitors

[paine]

"A few days ago, on the von Mises Instititute comment thread"

kill shot you poor dear if i'd known you needed
to talkso desperately you vamped for those ship in a bottle types
over at capin' von's con shop
i'da invited you
to my blog for a pranging

[paine]

killer

you run the credit system so close to the money line
you may have forgotten the ultimo commodity

shineful metalic money

locke the guy who said posssess
ends at spoilage
let the whole exploitation game
pass thru
by introducing
that single mine shaft

money of real scarcity
acting as medium of exchange
plus store of wealth
and not yet means of payment

still strictly avoids promises

a in god we trust everyone else pays cash
world preserves
the lockean world of 6 billion crusoe islands

[Spectator]

"Spectator, would it make sense to mint new marbles if the newly minted marbles were productively invested..."

Interesting question. The Austrians would say it would not, unless it is funded by real savings. As an entrepreneur, I'm inclined to think that it could be beneficial, but on average the Austrians are probably right.

For example, would you rather Warren Buffet invested to create the new marbles, or have the Fed create money for the same purpose? It's clear Buffet would be much more likely to make it worthwhile. And needless to say, the money created by the Fed is usually first given to our genius bankers. Not to say the govt. could not always make it work, but on average they would increase the costs for the Buffets of the world, for a net negative.

[paine]

prize float in the parade

front
" The Austrians would say it would not, unless it is funded by real savings."
middle
" As an entrepreneur, I'm inclined to think
that it could be beneficial "
back
" but on average the Austrians are probably right."

[Winslow R.]

I'd just confuse the analogy a bit by noting that there is a 'foreign' presence in this family.

Neighbors, China, Saudi Arabia, etc. are holding a lot of marbles and have pricing power to keep accumulating more marbles. They accumulate more and more marbles every day though at a slower rate than just a few months ago.

The family aggregate demand is falling as the kids mow the lawn for the 'neighbor' rather than dad. The neighbor accumulated marbles. Perhaps the neighbor was a better storyteller than dad? The kids would rather listen to the neighbor's story.

The Dad could try and break the neighbor's grip by slowing the overall demand sufficiently for the demand for the neighbor's stories to fall.

Or the Dad could create more marbles and watch the neighbor's marbles become worth less.

Hmmm.

[zinc]

Oh, I finally understand. The US lost it marbles eight years ago.

[reason]

I would have thought the logical solution was to slowly deleverage the system. Institute a regular shot of new marbles (say one a week). Ban everyone from creating new debts and reallocate the chores so that the system is sustainable. Eventually the debts will all be honoured.

That is one more reason, why I keep pushing for a GMI (guaranteed minimum income) system, or as I prefer to call it the pass go and collect $200 system. Without it, the monopoly game won't last long. Leverage is inherently unstable. On Angry Bear, I saw someone link to a film (Money as Debt video.google.com/videoplay?docid=-9050474362583451279 ). The first part was very good, the bit where it talks about possible alternatives not so very.